2. What is Capital?

In measuring kA and the WACC, we defined capital as debt and equity. Yet, if we want to implement these cost-of-capital measures, we have to be more specific. For instance, is debt just long-term debt or should it also include short-term debt, like short-term bank loans, accounts payable, accruals, and taxes payable?And does equity include all various types and classes of stock (voting bearer, nonvoting bearer, registered, preferred)?

The appropriate definition of capital depends on the question we are interested in.  In most cases, a definition whereby debt includes all forms of interest-bearing securities, and equity includes all classes and types of stock outstanding, is the most sensible and useful one.  That is the definition we use here. 

  • Interest-bearing debt means that items such as accounts payable are not part of debt.  The reason is not one of principle but one of practicality.  The interest a firm pays on the goods and services it buys on credit is included in the price it pays for those items.  It would be difficult to figure out the interest the firm has to pay to its creditors.  Moreover, we would have to treat those payments as financing flows (as opposed to operating cash flows) in the definition of free cash flows (FCFs);  
  • Similarly, taxes payable are not part of debt because we are usually not interested in looking at the state as a provider of capital.

 

However, we must make sure that the way we define capital when computing kA and the WACC is consistent with the way we compute free cash flows. In other words, once we have decided what providers of capital we are interested in, we have to make sure that we compute the cash flows generated by the firm for these providers of capital and not for anyone else.  If debt is therefore defined as interest-bearing debt, then we do not deduct interest payments or debt repayments in the computation of free cash flows.  Such payments are uses of the cash the firm has generated for distribution to its providers of capital.  In contrast, implicit interest and repayment of non-interest bearing debt such as repayment of accounts payable should be deducted.  We did so in our definition of free cash flows in the module Financial Planning, according to which we deducted changes in accounts payable.

We should reiterate, however, that the issue of the proper definition of capital is not one of principle.  What matters is what we are interested in.  What we have to watch out for is that cost of capital and free cash flows are measured in a logically consistent way.